innovest's long-term outlook for the economy and capital … · 2021. 1. 13. · etdl t t dddtl...

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Innovest’s Long-Term Outlook for the Economy and Capital Marketsy p

April 2013

Privileged and Confidential

INNOVEST’S CAPITAL MARKETS PROCESS

PRIVILEGED AND CONFIDENTIAL - INNOVEST PORTFOLIO SOLUTIONS, LLC2

GUIDING PRINCIPLES

1) A forward-looking, five- to ten-year perspective is essential for effective portfolio design.

2) Our analysis and recommendations are a combination of internal research from our consultants and analysts, along with input from more than 15 other investment firms with high-quality research.

3) Long-term forecasts consider a wide range of potential events and returns, and are designed to be both reasoned and reasonable.

4) Projections for asset classes and portfolios represent a midpoint of a range, rather than specific outcomes.

5) Clients need to carefully consider the characteristics, pros and cons of potential changes to their portfolios’ asset allocation, while keeping risk control and diversification at the forefront of the process.


INNOVEST’S INVESTMENT COMMITTEE


THE FIRST STEP: GLOBAL ECONOMICS


GLOBAL ECONOMICS

Monetary Policy

• Near-term: Stimulus from the world’s central banks should continue to support world

Central Banks’ Balance Sheets

continue to support world economic growth.

• Long-term: Potential unintended consequences from unprecedented stimulus, pincluding rising volatility and inflation.

As of 1/31/2013. Sources: Bloomberg and DoubleLine Capital.

Employment & Wages

• Near-term: U.S. real income and job growth remains sluggish.

• Long-term: Employment growth

U.S. Disposable Income Per Capita

and wages should be helped by an improving housing market, domestic energy production, and economic growth.


Reported 3/29/2013. Sources: dshort.com, Advisor Perspectives, Inc.

GLOBAL ECONOMICS, continued

Debt Levels• Near-term: Most governments

are paying low interest rates on their debt. L t Hi h

U.S. Federal Debt, Growth and Inflation

• Long-term: Higher government debt tends to suppress economic growth. The EU is likely to remain fragile.

• Consumers and companiesConsumers and companies have lower debt payments, supporting spending and investment.

Inflation

Sources: Reinhart and Rogoff, “Growth in a Time of Debt” and PIMCO.

Inflation

• Near-term: Inflationary pressures are subdued.

• Long-term: Unprecedented monetary stimulus increases

Economic Damage From Rising Oil Prices

the potential for rising prices.• Wild cards include economic

damage from rising oil prices, and benefits from U.S. energy production.


p

Real GDP one year after a $10/barrel increase in oil prices. As of 12/2012. Source: Moody’s.

GLOBAL ECONOMICS, continued

Fiscal Policy• Near-term: While government

stimulus supports economic growth, massive deficits add to heavy debt burdens

U.S. Federal Outlays and Receipts

heavy debt burdens. • Long-term: Increased

entitlement spending and higher interest on the federal debt threaten to expand deficits.

• Higher taxes suppress economic growth.

As of 3/31/2013. Sources: U.S. Treasury, BEA, OMB, CBO, and J.P. Morgan Asset Management.

Politics• Near-term: Political polarization

exacerbates the problems of government deficits and total debt.

Political Polarization

debt. • Long-term: Aversion to austerity

inhibits needed reforms in government and entitlement spending.

• Increasing government


• Increasing government regulation suppresses economic growth. *In roll call votes where the majority in one party voted the opposite way to the majority in the other.

Data as of 12/31/2012. Sources: voteview.com and J.P. Morgan Asset Management.

INNOVEST’S LONG-TERM ECONOMIC OUTLOOK

Innovest expects a continued sluggish economic growth environment for the U.S. and other developed markets over the next several years.next several years.

• Consumer spending growth should remain relatively healthy, supported by lower debt payments and gradual improvements in employment and wages.

• While supported by strong balance sheets, companies face modest revenue and profit growth.

U d t d t ti l i th l t t ti l f• Unprecedented monetary stimulus increases the long-term potential for instability, including accelerating inflation.

• Political infighting for at least several more years will likely delay significant reforms in entitlement and other spending, undermining long-term economic growth and stability.


ASSET CLASS FUNDAMENTALS AND PROJECTIONS


EQUITIES – FUNDAMENTALS

ValuationsStocks’ valuations in the developed markets, including the U.S., are modestly below their long-term averages which should support price

Equity Valuations

averages, which should support price appreciation.

Emerging markets’ valuations are close to their long-term averages.

Earnings GrowthSluggish economic growth in the developed markets is a headwind for profit acceleration Data as of 3/20/2013 Source: J P Morgan Asset Managementprofit acceleration.

As the world’s second-largest economy, China will have increasingly larger influences on global growth.

Data as of 3/20/2013. Source: J.P. Morgan Asset Management.

Dividend Payout Ratio

DividendsDividend payouts as a percentage of earnings have increased very slowly, restraining future returns. The

Data as of 3/31/2013. Sources: Standard & Poor’s


restraining future returns. The dividend yield for the S&P 500 is currently 2.2%.

Poor s, FactSet, J.P. Morgan Asset Management.

EQUITIES – INNOVEST’S OUTLOOK

Returns

Expect modest future returns from equities. Tempering our outlook are somewhat higher valuations (the largest impact on our reduction ofsomewhat higher valuations (the largest impact on our reduction of expectations) and modest future economic growth.

Quality

With relatively sluggish economic growth the stocks of companies with lowerWith relatively sluggish economic growth, the stocks of companies with lower levels of debt and more consistent earnings may be favored by the market. Quality large-cap stocks have underperformed in three of the past four calendar years.

Volatility

Stocks tend to be more volatile when economic growth is slow.

FocusFocus

Investors need to keep their focus on stocks’ total returns, risk, and diversification benefits, as opposed to concentrating primarily their dividends.


EQUITIES – INNOVEST’S FIVE-YEAR PROJECTIONS


Five-year projections are the mid-point of a range of average annual total returns.

EQUITIES – INNOVEST’S PROJECTIONS, continued

Long‐Term Projected Returns2013

Change from Long‐Term Projections in

2012 CommentsEQUITIES

Large Cap 8.50% ‐0.40%

• The expected average annual return is reduced by 0.40% from 2012’s long‐term projections.

• As P/E ratios have risen, there is a reduced tailwind for future returns.

• Companies have been slower than expected to increase dividends.

Small/Mid Cap 9.00% ‐0.60%

• The expected average annual return is reduced by 0.60% from 2012.

• The return premium for mid and small cap stocks over large cap is reduced from 0.7% to 0.5%, based on mid and small caps’ valuations being higher than average relative to large capsaverage relative to large caps.

International Large Cap 9.25% ‐0.15%

• Expected long‐term returns are reduced modestly (‐0.15%), based on somewhat higher valuations.

• Profit growth in the developed markets is likely to be restrained.

E t d l t t d d d tl

Emerging Markets 10.75% ‐0.15%

• Expected long‐term returns are reduced modestly (‐0.15%), based on somewhat higher valuations.

• Emerging markets exhibit good growth fundamentals and are reasonably priced.

• China’s economy will increasingly influence world growth.


FIXED INCOME – FUNDAMENTALS

Nominal and Real Interest Rates

Current after-inflation yields on 10-year U.S. Treasuries are slightly negative, versus a long-term average

After-Inflation 10-Year Treasury Yields

negative, versus a long term average of about +2.0%.

Inflation

While current inflation is relativelyWhile current inflation is relatively low and is not expected to accelerate significantly in the next few years, a long-term increase in inflation could put pressure on bond returns.

As of 12/31/2012. Source: Crestmont Research.

Credit Spreads

Investment-grade and high-yield spreads are below their long-term

Fl ti t l d

Credit Spreads

averages. Floating rate loan spreads are close to their long-term averages.


Current and 10-year spreads over Treasuries in basis points as of 3/31/2013. Sources: Barclays Capital, JP Morgan, BofA Merrill Lynch, Standard Poor's, U.S. Dept. of Treasury and Eaton Vance.

FIXED INCOME – INNOVEST’S OUTLOOK

ReturnsThe returns on high-quality bonds will be anchored by their current nominal yields, which are near 2.0% for taxable bonds and 1.5% for municipal bonds. After a three decade bull market in bonds expect very modest future returnsAfter a three-decade bull market in bonds, expect very modest future returns.

Active ManagementWhile interest rates could rise in the coming five-year period, it is beyond our (or anyone’s) expertise to predict when rates may begin to rise, how far they(or anyone s) expertise to predict when rates may begin to rise, how far they may rise, and for how long. Ongoing professional management remains essential in fixed income.

Opportunistic ManagersIt ti t b th hil t t i ti h t i llIt continues to be worthwhile to use opportunistic managers, who typically hedge out interest rate risk and select bonds with attractive risk/reward characteristics.

DiversificationFloating rate corporate loans continue to offer diversification benefits and the potential for good returns in an improving economy and when short-term interest rates rise.


FIXED INCOME – FIVE-YEAR PROJECTIONS



FIXED INCOME – PROJECTIONS, continued

Long‐TermProjected Returns

2013


2012 CommentsFIXED INCOME

Domestic Fixed Income 2.00% ‐0.50%

• Return expectations are reduced due to lower nominal and real yields on high‐quality bonds.

• The potential for higher interest rates, which are not a certainty, would further suppress future returns.certainty, would further suppress future returns.

Defensive Fixed Income 1.25% ‐0.15%

• Very low nominal and real yields on short‐term, high‐quality bonds will limit future returns.

• A projected increase in short‐term yields after 2014 should benefit returns somewhat.

Muni Fixed Income(Intermediate Duration) 1.50% ‐0.50%

• Return expectations are reduced due to lower nominal and real yields on high‐quality munis.

• Higher income tax rates increases munis’ relative attractiveness.

Defensive Muni 1.25% ‐0.15%

• Expected returns have declined due to record‐low yields on short‐duration munis.

• A projected increase in short‐term yields after 2014 should benefit returns somewhat.


FIXED INCOME – PROJECTIONS, continued


2013


2012 CommentsFIXED INCOME, continuedcontinued

Floating Rate Corp Loans 5.50% ‐1.00%

• While the Fed has committed to keeping short‐term rates low through 2014, a gradually improving economy should support returns on FRCLs.

• The asset class has garnered attention for its income, driving down future returns.

High Yield Bonds 4.50% ‐1.10%

• Yield spreads over Treasuries have declined to below‐average levels as income‐seeking investors have pushed down yields.

• High yield bond prices are above par, virtually eliminating any opportunity for price appreciation.

Global Fixed Income 1.75% ‐0.65%• Nominal yields on global bonds have fallen to near‐record lows.• Returns in excess of nominal income would be unlikely in the current rate environment.

• We expect long‐term returns for Stable Value to approximate

Stable Value 1.50% ‐0.20%

We expect long term returns for Stable Value to approximate 70% of the total return in Core Fixed Income.

• Low current yields on fixed income point to diminishing returns for Stable Value products.

• The Fed has signaled its intent to keep short‐term rates


Cash 1.25% ‐0.05% abnormally low until unemployment approaches 6.5%, which is not expected until late 2014.

ALTERNATIVES – FUNDAMENTALS AND OUTLOOK

Impact of Public MarketsWe expect quality (companies with lower

debt and more consistent earnings) to return to favor over the next five years,

Tight Credit Conditions

giving a boost to managers.

Due to regulation, fewer banks and international firms are actively participating in alternatives, which should provide better pricing for buyers.

Mid- and small-sized companies are relying more on private capital than loans from banks, creating opportunities for direct l dilending.

IlliquidityInvestors’ aversion to illiquid investments

indicates that illiquidity premia may be

Diversification Benefits

higher in the future.

DiversificationHedge funds, commodities and MLPs should

provide attractive diversification


p o de a ac e d e s ca obenefits in traditional portfolios.

ALTERNATIVES – FIVE-YEAR PROJECTIONS



ALTERNATIVES – PROJECTIONS, continued


2013


2012 CommentsALTERNATIVES

REITs 6.00% ‐1.0%• Due to capital inflows and price appreciation from yield‐seeking investors, REITs’ valuations have become less attractive.

R l ti l l l b l i th i l di

Commodities 6.25% ‐1.55%

• Relatively slow global economic growth, including decelerating demand from China, point to more modest prices increases for commodities.

• Most commodities have a negative carry (contango), which puts pressure on future returns.

• More normal (i e lower) correlations among stocksLow Correlated Hedge 7.75% ‐0.05%

• More normal (i.e., lower) correlations among stocks and bonds should provide hedge managers with good trading opportunities.

Direct Real Estate 8.00% ‐0.20%

• Improving property fundamentals, relatively low levels of new construction, and projected income growth should continue to benefit direct real estate.

• Sluggish economic prospects may temper returns.

Private Equity 11.5% ‐0.40%

• We continue to expect the average annual returns of direct private equity to exceed those of large cap U.S. equities by 300 bps.


ALTERNATIVES – PROJECTIONS, continued


2013

Change from Long‐Term

Projections in 2012 Comments2013 2012 Comments

ALTERNATIVES, continued

Listed Private Equity 9.75% ‐0.65%• We expect the long‐term return premium over large cap U.S. equities to be 125 bps, down from 150 bps, due to narrowing discounts.

Illiquid Credit 8.50% No change• The ongoing restrictive environment for bank lending to small businesses provides good opportunities for private lenders.

7 75%• We anticipate attractive returns based on distribution growth and cash flow yields

Master Limited Partnerships7.75%

(After‐tax) ‐0.35%distribution growth and cash flow yields.

• Due to tax structures and product limitations, the expectations are for after‐tax total returns.

I fl ti 2.25% ‐0.50%• We expect inflation to accelerate very slowly from

t l l d t l i h l b l thInflation current levels due to sluggish global growth.


ASSET CLASS FUNDAMENTALS AND PROJECTIONS


ASSET ALLOCATION STUDIES

Opportunities

• After significant price increases in a variety of equities bonds and other assets• After significant price increases in a variety of equities, bonds, and other assets over the past four years, there are limited opportunities to significantly improve the risk/reward characteristics of most portfolios.

• Floating rate corporate loan and opportunistic fixed income managers shouldFloating rate corporate loan and opportunistic fixed income managers should continue to generate beneficial diversification and returns in a low interest rate environment.

• Low correlated hedge strategies should help to mitigate portfolio volatility, g g p g p y,especially since high-quality fixed income instruments have a diminished ability to do so in a low yield environment.

• Clients need to carefully assess the pros and cons of changes to the asset allocation of their portfolios, and especially to maintain their focus on downside portfolio risk and diversification.


PORTFOLIO DIVERIFICATION IS ALWAYS ESSENTIAL

Annual Returns for Key Indices (2003 - 2012) - Ranked in order of Performance (Best to Worst)


Past performance is not a guarantee of future results. No investment strategy, such as diversification can guarantee a profit against a loss.

Source: Ibbotson Associates. Large Cap Equity stocks are represented by the S&P 500 Index; Small Cap Equity stocks are represented by the Russell 2000 Index; International Equity stocks are represented by the MSCI EAFE Index; Core Fixed Income bonds are represented by the BC Aggregate Bond Index; REITS are represented by the DJ Wilshire RESI Index; Commodities are represented by the DJ UBS Commodity Index; Hedge Fund of Funds are represented by the HFRI Fund of Fund Composite Index. This material has been obtained from sources considered reliable. No guarantee can be made as to its accuracy. Indicies are unmanaged and on cannot invest directly in an index.

innovest's long-term outlook for the economy and capital … · 2021. 1. 13. · etdl t t dddtl...

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